The big returns – and potential downsides – of swapping indexes like a hot potato

School is back and everyone is getting reacquainted with their friends – and the viruses they brought home from summer vacation. Alas, many unfortunates, myself included, have been afflicted by second-hand seasonal bugs.
September has also historically been inauspicious for the market, which can catch colds at the best of times and tumble into downturns or crashes.
While it’s hard to enjoy the market’s upside without suffering from its downside, the hot potato portfolio managed to avoid the pain of the 2008-09 crash to generate big returns. Its momentum-based approach fuelled an average gain of 12.8 per cent annually from the end of January, 1994, to the end of August, 2024.
The hot potato achieved success by investing all of its money in one of four major asset classes – Canadian bonds, Canadian stocks, U.S. stocks and international stocks – each month. The idea is to select the asset class with the highest returns over the prior 12 months and move everything into a low-cost index fund, or exchange-traded fund (ETF), that tracks it. (All of the returns herein are based on month-end data and the gains of the S&P Canada Aggregate Bond Index, the S&P/TSX Composite Index, the S&P 500, and the MSCI EAFE Index from Bloomberg. They include reinvested distributions and assume monthly rebalancing, but not fees, taxes, commissions or other trading costs.)
One might imagine that the hot potato swaps indexes each month as the market zigs and zags, but the top-performing index usually maintained its lead for many months. As a result, the portfolio traded indexes 1.9 times a year on average from the end of January, 1994, to the end of August, 2024.
The strong returns are grand but a word of caution is in order. The hot potato follows an aggressive strategy that requires a good deal of attention. As a result, it is not suitable for everyone and should be avoided by novices in particular. Those who follow it should also be mindful of its tax consequences and the use of tax-sheltered accounts may be in order.
Alternately, the passive potato portfolio offers a more conservative approach geared to a broader spectrum of investors. It buys an equal amount of the four major asset classes used by the hot potato with the goal of taking a fairly hands-off approach to investing via low-fee index funds and ETFs.
In addition, the passive potato can be readily modified to accommodate the goals and risk tolerances of individual investors. For instance, it can lean more heavily toward either stocks or bonds. Even better, major index fund providers offer low-cost balanced ETFs that track similar portfolios.
The passive potato portfolio generated average annual gains of 7.5 per cent from the end of January, 1994, to the end of August, 2024, which is decent for such an easy-to-follow strategy. Mind you, it trailed the hot potato portfolio by an average of more than five percentage points a year over the period.
You can examine the performance of both potato portfolios in the accompanying graphs. The first shows their long-term growth and the second shows how the portfolios fared in downturns.
The hot potato largely avoided the market crash that accompanied the financial crisis of 2008-09 with a timely shift to Canadian bonds. But the portfolio wasn’t a particularly strong performer in other downturns.
Mind you, the hot potato’s long-term performance wasn’t solely due to avoiding the financial crisis because its returns prior to 2008 and after 2009 were strong.
The first graph shows the hot potato’s good relative performance in the early years. It sported average annual gains of 15.1 per cent from the end of January, 1994, to the end of 2007, while the passive potato climbed by an average of 8 per cent annually. Moving past the 2008-09 period, the hot potato climbed by an average of 11.3 per cent annually from the end of 2009 to the end of August, 2024, while the passive potato advanced by an average of 8.7 per cent annually.
Turning to recent times, the hot potato currently favours U.S. stocks and has owned the S&P 500 since last December. It’ll be interesting to see how it fares should the U.S. Federal Reserve continue to cut interest rates, as is widely expected.
I’ve high hopes that both portfolios will fare well over the long term but investors should be prepared for a few colds along the way.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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